Financial Management & Cost Accounting

Lesson 22. PROFITABILITY RATIOS

Module 4. Financial statement analysis

Lesson 22

PROFITABILITY RATIOS

22.1 Meaning of Profitability Ratios

A class of financial metrics that are used to assess a business's ability to generate earnings as compared to its expenses and other relevant costs incurred during a specific period of time. For most of these ratios, having a higher value relative to a competitor's ratio or the same ratio from a previous period is indicative that the company is doing well.

Some examples of profitability ratios are profit margin, return on assets and return on equity. It is important to note that a little bit of background knowledge is necessary in order to make relevant comparisons when analyzing these ratios. For instances, some industries experience seasonality in their operations. The retail industry, for example, typically experiences higher revenues and earnings for the Christmas season. Therefore, it would not be too useful to compare a retailer's fourth-quarter profit margin with its first-quarter profit margin. On the other hand, comparing a retailer's fourth-quarter profit margin with the profit margin from the same period a year before would be far more informative.

The profitability ratios are used to measure how well a business is performing in terms of profit. The profitability ratios are considered to be the basic bank financial ratios. In other words, the profitability ratios give the various scales to measure the success of the firm. The profitability ratios can also be defined as the financial measurement that evaluates the capacity of a business to produce yield against the expenses and costs of business over a particular time period. If a company is having a higher profitability ratio compared to its competitor, it can be inferred that the company is doing better than that particular competitor. The higher or same profitability ratio of a company compared to its previous period also indicates that the company is doing well. The return on assets, profit margin and return on equity are the examples of profitability ratios.

The profitability ratio should be compared with the relevant time period. The profitability ratio of the industries that experience operations on the seasonal basis should be compared properly. For example, in case of the retail industry, high revenue is earned during the Christmas season. Hence comparing the profit margin of the 4th quarter with the 1st quarter of a retailer will not give clear picture of the profitability of the retail business. Hence in order to judge the profitability of the retailer perfectly, the profit margin of the 4^th quarter of a retailer should be compared with the profit margin of the 4^th quarter of the previous year.

The measures of profitability ratios are:

22.2 Gross Profit Margin

It gives the value of gross profit earned by the company over sale. The mathematical formula for gross profit margin is

Gross Profit Margin = (Total sales - Cost of sold goods)/ Sales

22.2.1 Return on equity

It gives the value of profit that is earned against every invested dollar in the stock of the firm. The mathematical formula for return on equity is

Return on Equity = Net Income / Shareholder Equity

22.2.2 Return on assets

It tells how the assets of the firm are used most effectively to earn profit. The mathematical formula for return on assets is:
Return on Assets = Net Income / Total assets

22.2.3 Profitability analysis ratios